What is the Chart of Accounts?
The chart of accounts is a tool that lists all the financial accounts included in the financial statements of a company. It provides a record of all the financial transactions that a company conducted during a specific accounting period.
Companies often use the chart of accounts to organize their finances by providing a complete list of all the accounts in the general ledger of the business. The chart makes it easy to understand the financial performance of the company at any given time.
The chart of accounts provides the name of each account listed, their brief description, and identification codes that are specific to each account. The balance sheet accounts are listed first followed by the accounts in the income statement.
The balance sheet accounts comprise assets, liabilities, and shareholders equity, and the accounts are broken down further into various sub-categories. The accounts in the income statement comprise revenues and expenses, and the accounts are broken down further into their sub-categories.
Setting Up the Chart of Accounts
When starting a new business, the first step is to set up a chart of accounts that the business will use. Typically, the accounts that are listed will depend on the nature of the business. For example, a taxi business will include certain accounts that are specific to taxi businesses, in addition to the general accounts that are common to all businesses.
In addition, the business will include a fuel expense account that is not common to all businesses, but it will leave out an inventory account since the taxi business is a service business that does not hold stock.
Typically, when listing accounts in the chart of accounts, you should use a numbering system for easy identification. Numbering also makes it easy to record a transaction. Small businesses commonly use three-digits numbers, while large businesses use four-digit numbers to allow room for additional numbers as the business grows.
Groups of numbers are assigned to each of the five categories, while blank numbers are left at the end to allow for additional accounts to be added in the future. Also, the numbering should be consistent to make it easier for management to compare the performance of the company during one period to the next.
Example: A large business numbering system
- Assets: 1000-1999
- Liabilities: 2000-2999
- Shareholder’s equity: 3000-3999
- Revenue: 4000-4999
- Expenses: 5000-5999
Categories on the Chart of Accounts
Each of the accounts in the chart of accounts corresponds to the two main financial statements, i.e., balance sheet and income statement.
Balance sheet accounts
The accounts are required when creating a balance sheet for the business. Balance sheet accounts comprise the following:
1. Asset accounts
The asset accounts provide a list of all the assets that the business owns. The assets may include intangible assets (such as trademarks, patents, and software), current assets (such as cash on hand, accounts receivable and inventory account), and fixed asset account (such as land, buildings, vehicles, and machinery).
Each asset account can be numbered in a sequence such as 1000, 1020, 1040, 1060, etc. The numbering follows the traditional format of the balance sheet, by starting with the current assets followed by the fixed assets.
2. Liability accounts
Liability accounts provide a list of all the debts that the business owes its creditors or what it will owe in future. Typically, liability accounts will include the word “payable” in their name and may include accounts payable, invoices payable, salaries payable, interest payable, etc.
Liability accounts also follow the traditional balance sheet format by starting with the current liabilities followed by long-term liabilities. The number system for each liability account can start from 2000 and follow a sequence that is easy to follow and compare in different accounting periods.
3. Owner’s equity accounts
Equity represents the value that is left in the business after deducting all the liabilities from the assets. Owner’s equity measures how valuable the company is to the shareholders of the company.
Some of the components of the owner’s equity accounts include common stock, preferred stock and retained profits. The numbering system of the owner’s equity account for a large company can continue from the liability accounts and start from 3000 to 3999.
Income statement accounts
The main components of the income statement accounts include the revenue accounts and expense accounts.
1. Revenue accounts
Revenue accounts maintain a record of the incomes that the business earns from selling its products and services. It only includes revenues related to the core functions of the business and excludes revenues that are not related to the main activities of the business.
Some of the sub-categories that may be included under the revenue account include sales discounts account, sales returns account, interest income account, etc. Numbering for each revenue account can start from 4000.
2. Expense accounts
The expense account is the last category in the chart of accounts. It includes a list of all the money spent in generating revenues for the business. The expenses must be tied back to specific products or revenue-generating activities of the business.
A simple way to organize the expense accounts is to create an account for each expense listed on IRS Tax Form Schedule C, and adding other accounts that are specific to the nature of the business. Creating the expense accounts based on Schedule C makes it easy for the business to calculate taxes due. Each of the expense accounts can be assigned numbers starting from 5000.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: